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I’m Raaid.

Twitter: @raaidahmad | LinkedIn | Quora

Thank you for taking the time to visit me on the web. Below are some of my favorite discussions and musings.

Raaid Ahmad on Statistically Interesting Podcast – I chat with Jake Stein, the COO of RJMetrics about diminishing returns multi-tabling online poker, Weebly’s technology stack, and how to think about organizing an analytics team that can drive company success.

Tried and True Investing Advice – This is my treatise on passive index investing, the difficulties of beating the market, and cognitive bias. I also take a separate deep dive into cognitive biases in investing.

Roboadvisors are good investment vehicles – In this post, I respond to an article by Blake Ross on the issues with Roboadvisors. I disagree with him vehemently.

cognitive biases investing

The Cognitive Biases That Plague Investors

It is very difficult to consistently invest profitably. Investment decisions are complex and as such are riddled with cognitive biases. Over a long enough time horizon even the most seasoned investors will succumb to many widely studied cognitive biases. They are human after all. This article discusses the cognitive biases that thwart investors. Some of these biases also prevent investors from sticking to tried and true investing advice.

The Investment Process

Investment decisions can be made in many different ways. Most of them involve answering different flavors of the same fundamental questions.

  • What opportunities are being sought?
  • What criteria are used to evaluate an opportunity?
  • What is the proper weighting of each criterion?
  • How are opportunities rigorously graded on each criterion?
  • What is a profitable purchase price?
  • Under what conditions should the asset be liquidated?
  • Navigating to the answers for each of these questions is fraught with risk of cognitive biases. The more these biases play into an investor’s decision the more likely the investor’s conclusions may be invalid. Below, I’ve listed some of the most common cognitive biases investors should be aware of. Additionally, I’ve included a brief example of an investment tactic or system that can mitigate the risk of this bias.

    Overconfidence Bias

    Overconfidence bias is a belief that one’s ability to beat the market is better than it truly is. More fundamentally, this effect means investors are more confident in their conclusions than they should be.

    Reducing the downside of being wrong is one way to mitigate this bias. Investor’s should always ask the question, “what if I am wrong?” and be comfortable with the answer to that question. Practically, setting (and more importantly, sticking to) position size limits can mitigate the effects of overconfidence. Setting reasonable limits ensures that investors do not “bet the farm” and lose everything if they are wrong. The risk of overconfidence is further mitigated by having a nuanced framework on how to size positions based on confidence level in the position. Forcing oneself to weigh the relative confidence of positions against one another encourages reflection on what one knows and does not know. Finally, incorporating consistent and measurable factors into the investment process will make it easier to spot overconfidence than if the entire process is qualitative. Occasionally revisiting past decisions and reviewing one’s success rate is often a humbling way to increase returns in the long run.

    Survivorship Bias

    Survivorship bias is most visible when investors are evaluating investment managers or making broad claims about the effectiveness of active management. The idea is that if hundreds of thousands of investors are betting on the markets, some will build an excellent track record not due to skill, but due to luck. This is a big reason investors often see the common disclaimer: “past performance is not necessarily indicative of future results”.

    Thoroughly understanding an investment manager’s investment process can mitigate the impact of survivorship bias. Investors should pay careful attention to the reasons a manager outperformed and not merely to the fact that they did outperform. An investor can develop a basis by which to differentiate the contribution of skill vs luck to the manager’s returns by deeply understanding the rationale behind the performance. Essentially, one must analytically assess the likelihood that a manager’s success was a byproduct of skill instead of luck. Separating the alpha and beta components of a manager’s returns can be a quantitative starting point for this discussion.

    Anchoring

    cognitive biases anchoring bias investing

    Anchoring is the tendency to place substantial (unjustified) weight on the first piece of information acquired in an investment decision. This often manifests itself as confirmation bias (don’t think I’ve forgotten) in favor of the original investment thesis. The current price of an investment is also an anchor that is frequently overvalued in decision-making

    Gathering informed opinions from others who have not yet been anchored is a method to mitigate the anchoring effect. Furthermore, managing an investment process to collect evidence before forming a hypothesis can also mitigate the effects of the anchor. A well-defined framework can specify which facts must be collected and what conclusions must be drawn without the need to start with questions about an existing hypothesis. Finally, a clear rubric assigning a weight (or ranges of weights) to various conclusions will limit anchor points from taking on more weight than they should.

    The bandwagon effect

    The bandwagon effect occurs when investment decisions are unduly influenced due to the conclusions of others. Imagine an investor who receives a stock tip from a friend. The investor may believe that his friend made an informed investment decision. In reality, that friend heard from his friend, who heard from her friend. This creates a situation where an investor may believe that 10 other disciplined investors did the work when in fact only one or two did. Many hedge fund analysts share their research with one another and as a result they have short (or long) positions in the same concentrated list of names (e.g Valeant).

    Following a disciplined investment process reduces the risk of herding. It is reasonable to weigh the opinions of others (based on your trust in them and your knowledge that the work they did deserves that trust). The risk, however, is overvaluing that opinion, especially when one has little understanding of why the recommendation was made in the first place.

    Loss Aversion

    The idea behind loss aversion is that humans have more aversion to loss than they have affinity for a gain of the same magnitude. The disposition effect is a specific case of loss aversion exhibited by investors. It is the tendency for investors to sell shares that have appreciated and hold onto shares that have an unrealized loss. No one likes taking a loss. The stock will bounce back eventually, right? right?

    Setting price limits and targets (though this is not without risks of it’s own) is a structured way to mitigate the impact of this effect. These targets and limits may be modified as new information is acquired. It is important not to let the disposition effect drive those changes, however, and ensure that the original investment process for calculating entry and exit points is followed. Finally, subordinating the weight placed on unrealized gains and losses (in fact an argument can be made that this should have almost no impact) can reduce the risk of falling prey to this bias.

    Confirmation bias

    cognitive biases confirmation bias investing

    Ah yes, the mother(fucker) of them all! Confirmation bias is the focus on finding and weighing more heavily, evidence that supports one’s initial hypothesis vs evidence that disproves it. Investors can browse their Facebook news feed for hundreds of daily examples of this phenomenon.

    As described above, adhering to the investment framework goes a long way in reducing confirmation bias. Adding detail around what criteria to use and how to measure it will reduce the likelihood that salient evidence is ignored. Additionally, playing devil’s advocate has helped substantially in my experience. Investors should independently try to make the strongest possible case for the investment as well as the strongest possible case against the investment. The investor can then think carefully about a trial where their life is at stake — they must make a case to a judge to go long or short. Which side is the investor most comfortable defending? This admittedly grim thought exercise compels decision-makers to carefully confront evidence on both sides.

    Other investing biases

    I’m tired of typing, so here is a laundry list of other biases to be cognizant of when investing:

    Availability bias
    Conservatism bias
    Zero-risk bias
    Pseudocertainty bias
    Outcome bias
    Nominal money illusion

    Unconscious Bias is Everywhere

    As should be evident, many of our investment decisions are steeped in unconscious bias. It is nearly impossible to remove all these biases from our decision-making. If we are cognizant of the pitfalls, however, we are far better armed to reduce the negative impact of the biases.

    One reason I am a huge proponent of roboadvisors is because they take everyday decisions out of our hands, frequently saving us from ourselves. A number of the systematic approaches outlined above to mitigate unconscious bias are programmed into Roboadvisors. The specifics of the algorithms have been rigorously tested.

    Investing is hard. Good luck out there.

    Find ways to compound everything you want to grow

    Your time gravitates naturally towards what you love to do. If what you love to do intersects with your work, then it is likely that often when you are not working you are doing things that further your excellence at your trade anyway. If these extra hours are the same as the hours you work, every year you do something gives you almost 2 years of experience. And if you work hard to be 30% more efficient, that multiplies the 2x. This consistent advantage compounds over time.

    The Power of Vote Swapping

    I think it is of the utmost importance that you vote for Gary Johnson in November. Now, before you have an aneurysm, hear me out.

    Most of you are probably aware that today Donald Trump is about a coin flip away from being the President. If you are as opposed to this outcome as I am, we need to band together to stop it. So why do we vote for Gary Johnson? The answer is vote trading.

    We can change the course of this election. Here’s how it works:

    1) If you live in one of these states:

    Alabama
    Arkansas
    California
    Hawaii
    Idaho
    Indiana
    Kansas
    Kentucky
    Louisiana
    Maryland
    Massachusetts
    Mississippi
    Missouri
    Nebraska
    New York
    Oklahoma
    Tennessee
    Texas
    Utah
    Washington, D.C.
    West Virginia

    2) Find all your friends who are undecided or are voting independent / green, who live in these states:

    Arizona
    Colorado
    Delaware
    Florida
    Iowa
    Maine
    Michigan
    Minnesota
    Nevada
    New Hampshire
    New Mexico
    North Carolina
    Ohio
    Pennsylvania
    Rhode Island
    Virginia
    Wisconsin

    3) Call them up. Catch up. Talk about life. Tell them about how concerned you are about a Trump presidency. Express understanding of their desire to give legitimacy to, provide support for, and protest on behalf of Gary Johnson and/or Jill Stein. Propose to them that you will vote for their preferred candidate (which provides presumably the majority of the benefit they’re after in terms of giving their protest national legitimacy in popular vote totals) in exchange for the promise that they vote for Hillary Clinton in November.

    Why is this valuable? Why is this important? With the help of some math, Nate Silver, and the abomination that is the electoral college, we can find out:

    If you live in a state that is highly blue (DC, HI, MD, VT, CA, MA, NY) or highly red (NE, WY, OK, ID, AL, WV), it stands to reason that your individual vote (for either major candidate) has a very low likelihood of determining the winner of your state’s electoral college votes. Conversely, if you live in a highly contested state (CO, NH, NV, FL, PA, NC, MI), your chances of flipping the state are far higher. This is represented wonderfully by FiveThirtyEight’s “Voter Power Index.”

    The “Voter Power Index” represents the relative likelihood that an individual voter in a given state will decide the outcome of the electoral college vote. Below is FiveThirtyEight’s assessment of the states whose individual voters have the most influence. This is largely a function of the competitiveness of the state and the expected number of voters. For example, NH’s 4.3 is twice VA’s 2.1, indicating that a New Hampshire voter is twice as likely to change the outcome of the election as a VA voter.

    Voter Power Index - Most Valued States

    Next, we look at the states in which an individual vote is far less likely to change the outcome of the election. This is where it gets interesting.

    Voter Power Index - Least Valued States

    Essentially what these charts tell is us that a New Hampshirite’s vote is over 43 times more influential than a Californian’s vote. I live in California, so this makes me sad.

    But if I can trade my vote (and I did with 4 of my friends – who put their country above themselves) for votes in Florida, Pennsylvania, and Ohio, I can increase the power of my vote by 103000%. Now, normally I would recommend trading your vote 1 to 1 with a friend to be fair. But if you have wonderful, generous friends like mine, you can ask them if it is OK if you make the same agreement with others so that you trade your vote multiple times (the stakes are high, it’s worth asking).

    Now, the first question I get is, “How do you know people will actually do it?” The answer is I don’t. I have no way of enforcing this swap, but I intend to keep my side of the bargain. I’ve done this with my friends and I recommend you start there too. If we can’t trust our friends, what kind of society are we? Look on the bright side, even if your counterparts do not honor their part of the deal, they were going to vote that way anyway and your vote doesn’t even matter that much relative to theirs (sorry, but it’s true).

    We don’t need to make a big splash and we don’t need to completely change how we spend our time — we merely need to make a trade and pass it on. Share this idea. Talk to friends. Talk to friends about this idea. We *can* change this election.